What Is Preservation of Capital?

What Is Preservation of Capital?

Preservation of capital is a conservative investment strategy where the primary goal is to preserve capital and prevent loss in a portfolio. This strategy necessitates investment in the safest short-term instruments, such as Treasury bills and certificates of deposit.

Preservation of capital is also referred to as capital preservation.

Understanding Preservation of Capital

Investors hold their funds in various types of investments according to their investment objectives. An investor’s objective or portfolio strategy is dictated by a number of factors, including age, investment experience, family responsibilities, education, annual income, etc.

These factors typically point out how risk-averse an investor is. Common investment objectives include current income, growth, and capital preservation.

Risk Tolerance and Investment Objectives

The current income strategy focuses on investing in securities that can create returns quickly. These include securities such as high-yield bonds and high dividend-paying stocks. The growth strategy involves finding stocks that emphasize capital appreciation with minimum consideration for current income.

Growth investors are willing to tolerate more risk and will invest in growth stocks that have high price-earnings (P/E) ratios. Another common type of investment objective for a portfolio is capital preservation.

Securities that are used for the preservation of capital have little to no risk and, in effect, smaller returns compared to current income and growth strategies. Preservation of capital is a priority for retirees and those approaching retirement, since they may be relying on their investments to generate income to cover their living expenses.

These types of investors have limited time to recoup losses if markets experience a downdraft and give up any potential for high earnings in return for the security of existing capital. Since retirees want to ensure that they don’t outlive their retirement savings, they usually opt for investments with minimal risk such as U.S. Treasury securities, high yield savings accounts, money market accounts, and bank certificates of deposit (CDs).

A majority of investment vehicles used by investors focused on capital preservation are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. In some, but not all instances, these investors may only be investing their money for the short-term.

Drawbacks

A major drawback of the capital preservation strategy is the insidious effect of inflation on the rate of return from "safe" investments over prolonged periods of time. While inflation may not have a significant impact on returns in the short term, over time, it can substantially erode the real value of an investment.

For example, a modest 3% annual inflation rate can slash the real or inflation-adjusted value of an investment by 50% in 24 years. The amount that you have is preserved but, in some cases, the interest you earn on a savings account is unlikely to increase enough in value to offset the gradual loss of purchasing power that is a result of even moderate inflation. As a result, in “real” terms, you could lose value, even though you have the same amount of cash.

For this reason, investors utilizing the capital appreciation strategy are better off investing in inflation-adjusted investments, such as Treasury Inflation-Protected Securities (TIPS), which are issued by the U.S. government.